Definition
The term tax shelter is used to describe a variety of ways to protect income, or earnings, from federal or state taxes. Individuals looking to avoid paying income taxes to the federal government are sometimes tempted to enter into agreements involving tax shelters that are deemed illegal.
Explanation
Not all tax shelters are illegal. In fact, any qualified retirement plan that allows employees to avoid or defer paying taxes, and promotes saving for retirement, is considered a tax shelter. One of the more common tax shelters that individuals can take advantage of is a Roth IRA.
While an IRA allows an individual to avoid paying future taxes on interest earned, it also serves an economic purpose: retirement income. Roth IRAs, Traditional IRAs, SIMPLE IRAs, 401(k) plans, and 403(b) plans are all examples of legal tax shelters. Corporate tax shelters include tax deferral or reduction tax laws, such as accelerated depreciation, which are used to encourage new investments.
Transactions that have no economic purpose, other than reducing income taxes paid, are considered abusive tax shelters and are to be avoided.
